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Modeling Cash Flows with Constant Leverage: A Note

Author

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  • Joseph Tham
  • Ignacio Velez-Pareja

Abstract

It is widely known that if the leverage is constant over time, then the after-tax Weighted Average Cost of Capital (WACC) is constant over time. In other words, it is inappropriate to use a constant after-tax WACC to discount the free cash flow (FCF) if the leverage changes over time. However, it is common to find analysts who inconsistently use a constant after-tax WACC even if the leverage is not constant. In this teaching note, we use a simple numerical example to illustrate how to model cash flows that are consistent with constant leverage. We verify the consistency of the example with two basic principles: conservation of cash flows and conservation of values.

Suggested Citation

  • Joseph Tham & Ignacio Velez-Pareja, 2005. "Modeling Cash Flows with Constant Leverage: A Note," Proyecciones Financieras y Valoración 1897, Master Consultores.
    • Handle: RePEc:col:000463:001897
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    Cited by:

    1. Ignacio Vélez-Pareja & Rauf Ibragimov & Joseph Tham, 2008. "Constant Leverage And Constant Cost Of Capital: A Common Knowledge Half-Truth," Estudios Gerenciales, Universidad Icesi, June.

    More about this item

    Keywords

    WACC;

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis

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